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We all like profit, and we all want more. So what do we mean when we say we want 'increased profitability'?
In the July edition of Management Memos, we went a long way to describe ways in which you could use your new budget to greatly improve your cash position. We also noted that those steps would make your business more profitable too.
How Do You Report Profit?
There are lots of ways, but for most of us the two final numbers that matter are statutory profit, and trading profit.
Statutory profit is the profit you report according to law - in effect, your taxable profit. We want to minimize the tax you pay, so we'll ignre statutory profit.
Trading profit, on the other hand, defines how good you and your business are at making money. It is the result of day-to-day operations where you work hard and build the business. Don't look at your tax return to see how profitable you have been - but do look at your trading accounts which shows the raw Information.
How Do You Measure Profit?
Profit is usually expressed in one of two ways - as a return on the money you have invested, or the return on the level of business you're doing.
Suppose you have loads of money invested, but the return was less than inflation after tax, you'd go backwards every year. Better to invest the money somewhere else. For instance, imagine that you had good sales at very small margins and with high expenses. Good sales, low profit, unsatisfactory return for having that much money tied up.
Similarly, if you are doing a mountain of business on, say, a made-to-order basis with almost no stock, and rented or leased facilities and equipment. There is Even a low profit would be a terrific return on investment, because there almost none of your own money tied up. But if you don't get a reasonable amount of profit compared with the money you are turning over, that's not a good business either.
So you need both. A good return on your money, and a good return on the sales you make.
Return on Investment
Nothing's ever simple, right? In this case, there are two ways of looking at the return on the money.
If you have set up in business using a lot of other people's money, typically by renting or leasing almost everything you need, you'll have a good business judged on the return on your money, because so little of it is involved.
But if you then consider that return on funds employed - so you take into account all the money that is involved in running the business, it will not look so good - it can't - and it might look actually a rather poor return. See what we mean - it isn't simple!
We can simplify this though. If most of the money in the business is yours, the Return on Funds, related to your own money, is pretty robust indicator. You won't be a highly leveraged business, you will be rather conservative, and you can use the kind of 'rule-of-thumb' that applies.
On this basis, the profit you make before you take out interest and tax should not be less than 25%. That way, after tax has been taken, you will be seeing a return which covers the 'cost of capital' (what you would have to pay to borrow all that money), plus cover the risk of doing business. That 'risk premium', the profit you get for 'having a go' and taking the risk, should not be less than 5%, and perhaps more like 7% or 8%.
It is a good idea to look at your own figures now and do the sums. Decide for yourself if you're doing OK
Return on Sales
When you are making sales, you're using cash for your stock, trading with customers who are protected by consumer law, and at least in some respect, generating debtors who may or may not pay as required. You need an adequate profit for all of those risks, and even if your return on funds is good, you also need a good return on sales to cover the risks of simply trading.
What should that return be?
The short answer is "as high as you can make it!" - but you need a better guide than that. When looking at the return on sales, you are considering the financial risks of doing business. It's those risks that need to be covered.
As we saw in the July edition, a return of 10% to sales in the business example cited there provided a little extra cash. In the improved scenario, more sales would produce more cash for the owners when they got both a good return on sales, and good efficiency in their stock. That means that there is no hard and fast rule on this ratio.
If you're a SME that is managed by the family, and with a major (paid) staffing contribution from family members, a good return on sales would be about 12%. Fifteen percent (15%) is brilliant, ten percent (10%) is OK, and anything lower needs some attention.
That's the measure of profitability, but how do you manage it?
This is an important part of the whole tapestry of management woven around your business. It's too big to discuss in a forum like this. Here are some clues:
Negotiate with suppliers on price, delivery, and payment terms. All of these facets of supply affect your profitability
Look at your expenses - and work out strategies for a continuous long term reduction in expenses
As a rule, you will need to reduce your expenses by about 1.5% of sales every year to stay in front. Now that is really hard to do!
Look at your prices - and use sophisticated pricing techniques to wring our very cent of gross profit from every sale
If you're a retailer, look at the most profitable floor areas in your store, and use them for the high margin items in your range.
These things aren't easy - but they are doable. Contact a professional source of help, like My Red Zebra!
We can help you see your strategic strong points, protect your strategic weak points, and win on the digital sales front. And then you can just hang up. NSA!
Phone us (see the numbers below) or use the contact form here to get help. Absolutely obligation free.
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Any advice, information or comment contained in this document is general in nature, and should not be relied on as the basis for any specific commercial, business, employment, or financial decision. Specific advice should always be obtained for each individual circumstance. Accordingly any advice, information or comment contained herein is for general guidance only.